At one time, the topic of technology stocks was a regular one in this
space. So many people were invested in the volatile sector that it
deserved lots of attention as uncertainties started to surface. After
a hiatus from discussing tech stocks, this week's article revisits the
popular sector, their valuations, and what the future might hold for
today's buyers.

Previous views on tech stocks

Some of the information in this old, May 2000 article is
dated, but it's the first time I warned publicly of the high
valuations in tech stocks. After that article appeared, I wrote five
separate articles in this space, from September 2000 through March
2001, warning of high valuations among tech stocks.

By October 2001, 9-11 had happened and stocks were crushed. My advice
at that time was, from that article:

"I'm still a little leery about technology. Now, I'd say this is
probably a decent time to start building a position very slowly for
those who are bullish on technology longer term. Everybody hates
technology right now. With lots of economic stimuli at work, I'd be
willing to go out on a limb and say that tech stocks may start to
produce respectable returns at some point next year or two, but lots
of patience (and a strong stomach) is required."

But then in early 2002, tech stocks had run up so briskly that I
advised taking some money off the table. Then, last fall I reasoned
that it made more sense at that time to get technology exposure
through venture capital, or labour sponsored funds. My recommendations
have been as volatile as the Nasdaq.

Having come off another strong run since the fall, many people are
again tempted by the lure of high returns and how bright the future
might be.

Valuation

A discussion of future potential is incomplete without first
addressing the price paid today - i.e. current valuations. There are
currently more than 3,600 stocks traded on the Nasdaq - the top 25 of
which account for nearly 45 percent of the Nasdaq's total market
value. Here is a weighted average valuation summary for the largest 25
stocks trading on the Nasdaq:

Recall that stock valuations represent the market's expectation of the
future. Admittedly, the market doesn't seem to peek too far into the
future. The valuation figures noted just above have some pretty high
expectations built into them.

For the purposes of the illustration that follows, suppose the Nasdaq
market is a single stock with the valuation characteristics noted
above. Let's also suppose that investors expected to earn a compounded
rate of return equal to 10 percent per year. This hypothetical stock,
trading at 34 times last year' s earnings, would have to grow its
bottom line profits by a full 11 percent per year for the next ten
years - without missing a beat.

To put this into perspective, let's make some assumption about what
U.S. inflation will be going forward. Over the past seventy-seven,
it's been in the 3 percent per year range. Let's use that historical
average. During that same period, corporate profits have grown an
average of 1.5 percent above inflation.

To further put the historical profit growth into perspective, the
1990s was the decade with the highest "real" (i.e. net of inflation)
U.S. profit growth of any decade starting after 1929. During that
ten-year period, corporate profits (as measured by S&P 500 profits)
grew at a rate of nearly 5 percent above inflation.

Even if we repeat that decade, with 3 percent inflation, total
earnings growth will be 8 percent annually. I estimate that would
translate into a rate of return of about 8.5 percent per year. But,
we're not likely to repeat (or exceed) the biggest growth decade in
U.S. history. Going back to the historical average of 1.5 percent
annual profit growth (net of inflation) translates into investment
returns of about 6 percent per year. Given the extreme volatility of
the Nasdaq, there's a good chance that most people wouldn't actually
earn that much.

In other words, I don't expect that today's buyers of tech stocks will
be well rewarded for the risk they're assuming.

Investors and advisors must pay great attention to what you're buying
and make sure expectations can stand up to scrutiny. Otherwise, be
prepared for disappointment.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in
Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and
provides independent investment research to financial advisors. He can be
reached at dha@danhallett.com

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